First REIT Unaffected by New Tax Regulations; Material Impact on LMIRT

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Earlier this year, the Indonesian Government has passed new regulations issued under Government Regulation No. 34/2017 (GR-34) regarding income tax on the rental of land and/or building. This regulation become effective starting 2 January 2018.

The material point to note about this changes are that, income received from land and/or building rental includes all amounts paid or payable by tenants by whatever name and in whatever form, including maintenance cost, service charge, security cost, and other facilities, whether agreed under a single agreement or in separate agreements.

According to an announcement posted by LMIRT, certain maintenance services for LMIRT's properties are outsourced to a third-party service provider, who would collect service charges and utilities recovery charges from the tenants.

These additional taxes now need to be withheld by the tenants and therefore reduce the rental income to LMIRT. As a result, this would reduce LMIRT’s rental income directly affecting its DPU. The taxes however will have no material impact on the trust’s NAV.

Based on the pro-forma results for the full year DPU for FY2017 as posted in the announcement, had the new regulations had taken affect in 2017, the DPU would have fallen from 3.44c to 3.19c which is a 7.25% fall.

From a yield perspective, based on 40c price, the DPU fall will result in the yield compressing from 8.6% to 8.0%.

LMIRT’s sister REIT – First REIT on the other hand would not experience any impact from this new tax regulations. This is due to the triple-net lease structure put in place during the term of each of the Master Lease Agreements, the Master Lessee will bear all operating costs relating to the Properties, including Maintenance, Certain taxes and Insurance. In other words, the changes to the tax structure will directly impact First REIT’s tenants instead of the REIT’s unitholders and the tenant would now need to bare these increase in tax burden. The minimal impact to First REIT is confirmed in its announcement entitled NEW TAX REGULATIONS ON INCOME RECEIVED OR EARNED FROM LAND AND/OR BUILDING LEASES IN INDONESIA.

This lesson highlights the advantage of the Master Lease Agreements with triple-net lease tenancy structure which allows unitholders to have better predictability of the trust’s income. This also clearly tells us that tax regulations are also a risk in our investments.

Some examples of other REITs with Master Lease Agreements with triple-net lease structure put in place are Parkway Life REIT and Keppel DC REIT. These REITs are more likely to be insulated (but not free!) from tax regulations changes which miminizes the risk to investors.

From what we can gather (within our limited resources!), this Indonesian tax regulation changes was passed sometime in January 2018. If this were true, it brings about another question, why had LMIRT's management taken so long to assess and announce the impact of this tax change? Does this indicator an advance notice of a potential decline in its DPU expected for Q1-2018? Is the management trying to soften the blow to investors by preparing the market ahead of a decline in its DPU?

There are many questions which perhaps we will only find out after the Q1-2018 results are released.

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